Should investors be increasing equity allocations to emerging markets?

Emerging markets’ equity performance has struggled relative to the developed world over the last few years, leading some investors to question the rationale for an allocation to these markets.

11 December 2014

Emerging markets’ equity performance has struggled relative to the developed world over the last few years, leading some investors to question the rationale for an allocation to these markets.We believe this is short-sighted. Emerging markets are nowadays simply too significant for investors to ignore. Their stockmarkets represent around 11% of the MSCI All Country World index, while their combined GDP accounts for a third of the global economy. We believe that, given these statistics, all investors should be considering an investment in this part of the global market. While we believe there is a good structural argument for an allocation to emerging markets, our focus in this article is on the medium-term tactical case and whether investors should be looking to increase their allocations.

The strategic caseUnderstandably, emerging markets were traditionally seen as a higher risk asset class, particularly following the currency and debt crises of the 1990s. As a result, institutional investors viewed an allocation to the developing world as short term and tactical, rather than strategic. This picture has been changing dramatically over the past decade or so.

Since the 1990s, many emerging economies have been transformed. As a group, they have grown 3–5% faster than the developed economies, a performance that has been highly correlated with emerging equity markets. While the growth gap has been narrowing recently, in our opinion it does not change the justification for further strong stockmarket absolute and relative returns. Emerging markets’ share of global growth continues to increase – China contributed around 40% to global growth in 2013, more than the US – and they are expected to account for over 60% of global growth for the foreseeable future.

This rapid growth represents a major structural change to the world’s economic system. It has been caused by the arrival of over 2.5 billion people in China and India, who are for the first time starting to acquire wealth and disposable income. Bank of America Merrill Lynch estimates that global wealth will increase from €313 trillion in 2010 to €667 trillion in 2030, with emerging countries responsible for 80% of this new wealth. And, in a break from the past, it will be domestic demand growth rather than exports that will be the primary driver of emerging economies’ growth (Figure 1).

As a result of these trends, economic fundamentals in the emerging world tend to be stronger than for developed markets. The world is still feeling the repercussions of a global financial crisis caused by inappropriate lending, borrowing and over-leverage in the developed world. In contrast, by and large, the emerging world is typically characterised by high saving ratios, low levels of debt and prudent lending policies. While economic health varies between countries, on several other measures, such as current account and fiscal balances, the fundamentals are generally stronger in emerging markets than the developed world, which is still struggling to recover from the global financial crisis.

The tactical caseThe near-term catalyst. Part of the explanation for recent disappointing emerging market performance has been that both GDP and earnings have surprised on the downside. Cyclical pressures, including a poor external environment, low commodity prices and local currency weakness, have weighed on profitability. However, history tells us that emerging markets are likely to be among the primary beneficiaries of a pickup in global growth. Consensus estimates of global growth for 2015 and 2016 are currently 3.0% and 3.1% respectively1.

While domestic consumption remains the primary driver of emerging growth, a global cyclical upturn should support exporters in particular. This would be a welcome development for emerging markets as exports have detracted from growth there since the global financial crisis. They have indeed recently started to turn positive, supported by generally competitive exchange rates, as can be seen from Figure 2. This in turn should be positive for economic growth and improve the prospects for positive earnings revisions. The consensus forecast for 12-month forward corporate earnings growth, as collected by data provider IBES, is currently around 10% for the MSCI Emerging Markets Index.

1Source: Bloomberg, 27 October 2014

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Important Information: The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.
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